The Gateway to Algorithmic and Automated Trading

Where credit's due

Published in Automated Trader Magazine Issue 29 Q2 2013

Back in the 'good old days', life seemed so simple: dealers warehoused vast amounts of corporate bonds, and investors picked up the telephone when they wanted to buy or sell. But capital requirements and regulation have led to a dramatic fall in banks' balance sheets and the buy-side is being asked to play a bigger role to boost liquidity. As electronification takes hold, can the elusive all-to-all model take off or is something else needed? Adam Cox reports.

Where credit’s due

There is a data series from the New York Federal Reserve that fixed income executives frequently cite. It shows the amount of corporate bonds with maturities of more than a year held by primary dealers. Since these are dealers we're talking about, the aggregate total is a useful illustration of available liquidity. In October 2007, a year before the collapse of Lehman Brothers, those holdings topped $230 billion. By the time the crisis was unfolding, the total was hovering just above $100 billion. Earlier this year it was less than half that.

George Harrington

George Harrington

"From our standpoint, the key really is market readiness. The paradigm shift will occur when you have the buy-side going from liquidity-taking to liquidity-provision."

The financial crisis and the resulting regulatory changes have ushered in a fundamental shift in the way corporate bond trading works. As banks have had to reduce their balance sheets, a good deal of bond trading power has shifted to the buy-side. But asset managers have been unwilling or unable to effectively wield that power to date. Add to that some of the complexities inherent in the corporate bond market, and the slow pace of adoption of electronic trading relative to other asset classes, and the result has been illiquid markets.

"You have to look at the picture from a 30,000 feet perspective," said Robert Urtheil, head of Europe and Asia at bond trading platform MarketAxess. "The corporate market or the credit market is today where many other markets were 10 years ago."

Corporate bonds, he said, are seen more as an investment vehicle and the degree of electronification lags behind other asset classes.

"In the credit market, you literally have securities which haven't been traded for days, weeks or even months," Urtheil added. "So to take the risk, to put your finger out with a price, versus just asking for a price, is obviously something an investor will think twice about."

George Harrington, head of global fixed income trading at Bloomberg, sees those behavioural factors as a core issue in terms of the market's development.

"From our standpoint, the key really is market readiness. The paradigm shift will occur when you have the buy-side going from liquidity-taking to liquidity-provision."

But buy-side trepidation is only one of the obstacles standing in the way of a vibrant corporate bond marketplace. The goal of having an all-to-all market for corporate bonds, akin to an exchange scenario for equities, has also long been complicated by simple logistics.

Robert Urtheil

Robert Urtheil

"You have to look at the picture from a 30,000 feet perspective. The corporate market or the credit market is today where many other markets were 10 years ago."

There may be one General Electric issue of common stock that the investment community cares about, but there are about 600 different GE bond issues, all of which have varying coupons and maturities.

"On average in Europe, you have about 50,000 to 70,000 items outstanding in the credit market. That alone leaves you with a marketplace that has to work differently," Urtheil said, contrasting it with a liquid listed derivatives market which might be dominated by a handful of products accounting for most of the volume. "So it is just more difficult in an opaque, illiquid market to make prices, and this is where asset managers see the benefit of the market-making capabilities of the banks," he said.

Complicating the problem is a complex competitive landscape, with single dealer platforms, multi-dealer venues and buy-side initiatives all engaged in a high-stakes scramble for liquidity. As a result, the word that comes up most frequently among executives describing the process underway is 'evolution'. This is not just a battle for market share, but rather one to see how the species will adapt to colder climes.

Equity envy

Spurred on by a liquidity-starved buy-side and guided by a French initiative called the Cassiopeia Committee, companies have made a few fledgling efforts to establish all-to-all markets where investors could trade with anyone out there. But whether the buy-side will do that is very much an open question. Some say it's about to happen. Some say that if it was going to happen it would have done so by now.

The Cassiopeia Committee defined criteria for bond trading order books, including the provision that the buy-side trade through a sponsor firm which provides anonymity.

MTS, the European electronic bond trading market owned by the London Stock Exchange, is one of the companies pursuing the order book model. MTS Credit includes this option alongside its traditional dealer pages where investors can request for quotes (RFQ) from the dealers on its network.

In April, MTS announced that Credit Agricole had become its first prime bank acting as a sponsor firm. Investors who want to trade directly with other investors can do so via the sponsor firm, which provides a line of credit and anonymity. The order book has some 2,500 investment grade bonds on it, of which about 1,500 are corporate issues. The other 1,000 are made up of supra-nationals, sub-sovereigns and agencies.

"For the first time, the buy-side can actually interact directly on the order book, not just look at the order book and call up banks," said Guido Galassi, a product manager at MTS.

Galassi said MTS wants to add a couple more sponsor firms by the end of the year, but said that ultimately the number doesn't matter in terms of whether the model will work or not. Due to the anonymity, scores of investors can all trade via the same sponsor firm without any issues.

Galassi also tempered any idea that the order book would revolutionise the marketplace.

"The order book is going to be an alternative to more traditional ways of trading. It will not necessarily take over," he said. "There are ways of trading that have to complement each other. There's definitely a problem with liquidity right now, so it all goes towards solving this problem."

Dom Holland, head of credit ecommerce at Deutsche Bank, is sceptical about the prospects for a thriving order book in the fixed income market.

"A number of buy-side firms have been discussing the need for a lit order book, but I'm not convinced that the marketplace is ready to move to that," Holland said.

"The theory around a perfect order book, like an equity market, would be great," he said, but he added: "If there'd been an opportunity for an order book to be successful it would have actually happened before we had stressed markets. It would have happened during normal market conditions."

He raises several issues. For a start, he said, the traditional client-to-dealer model has meant that banks have been able to glean vital information about where demand is, and this facilitates the new issues market. All parties have an interest in that model continuing.

"When you look at the trades that are going through electronic trading platforms at the moment - which would be the most liquid, so you would think that's where you could get the most crossing opportunity - the numbers show that it's only about 8-10% of this activity would be a client-to-client cross."

Holland has been a member of the strategic committee for BondMatch, another order book initiative, which has been developed by NYSE Euronext. "I think it's very healthy to be challenging the model with the extreme version of the current protocols, which would be the order book."

But he said the amount of trade that could take place via crosses is actually limited.

Holland points to analysis conducted with clients and with other firms such as Tradeweb, Bloomberg and MarketAxess on the opportunity for client trades to cross.

Guido Galassi

Guido Galassi

"There are ways of trading that have to complement each other. There's definitely a problem with liquidity right now, so it all goes towards solving this problem."

"When you look at the trades that are going through electronic trading platforms at the moment - which would be the most liquid, so you would think that's where you could get the most crossing opportunity - the numbers show that it's only about 8-10% of this activity would be a client-to-client cross," Holland said.

"There's a reason for that," he added. "They all have very similar investment strategies." And the net result, he argued, would be that an order book model wouldn't necessarily increase the opportunity or their probability of trading.

Finally, there is a fundamental problem, Holland said, which is what fuels the buy-side's caution. Whenever institutions put a price out, as soon as someone wants to trade in size, the market immediately moves away. "I don't think it's going to be any different than if they post an offer in an order book, with nothing on the bid side. So I think they're automatically establishing some negative impact on their portfolio by doing that."

Galassi of MTS said that in an order book, it just comes down to being smart about how orders are posted.

"It's what happens typically in an order book," he said. "Obviously, you have to play your cards right. We don't think that there will be block trading happening on the order book; and this is the feedback we get from everyone."

The use of platform aggregation has a precedent too, and Galassi said that those questioning the coexistence of several platforms should consider the experience in other sectors.

"They haven't seen what has happened over the years in other sectors such as the government bond world. We've seen that. We've seen how the market can evolve," he said. "A lot of people are concerned, for sure, but it's normal to have concerns when dealing with something new."

At the moment, if any all-to-all model is to work it would probably need to be for a limited segment, a number of executives said.

"When you talk about the most liquid instruments, the buy-side doesn't seem to feel there are issues finding liquidity. That's where it seems as if an all-to-all model is more likely to succeed," Bloomberg's Harrington said.

x"The less liquid instruments are where there are issues finding liquidity; the likelihood of finding crossing or matching opportunities becomes significantly lower and therefore it's a bit of a conundrum."

Galassi of MTS meanwhile is patient to see how things pan out. "We'll see where we are in a year's time. It might be that the order book will be used for more illiquid bonds," he said.

"For us it was important to offer everything to the buy-side. You don't want to disintermediate your dealers. You want to keep activity going through the traditional ways of trading: RFQ, bilateral, one-to-one or one-to-many, dealer pages," he said.

Primary Dealer Corporate Bond Inventory Primary dealer holdings of US High-grade corporate bonds have declined approximately 80% since the credit crisis and 40% since May 2011

Primary Dealer Corporate Bond Inventory

Primary dealer holdings of US High-grade corporate bonds have declined approximately 80% since the credit crisis and 40% since May 2011

'Give to get'

Deutsche is pressing for a different approach. It believes there could be a way for the buy-side to interact more successfully with the marketplace.

"The way we transition the market," Holland said, "is that we harness relationship and the client's need to reduce the market impact of their potential trade."

The solution would be a dealer-sponsored matching engine, where clients would be able to enter interest via a dealer. "It's a give-to-get model, so the only way that a buyer would be alerted that there's a seller is once there is that selling interest posted within the matching engine. And at that point there would be a bilateral negotiation on price," he said.

The idea is the result of numerous conversations with investors and trading firms.

"The key point of this is that it's a market-led solution, and it's inclusive. The success of it will be having more, not less, participants. So we're trying to concentrate liquidity in one venue, away from the fragmentation of the single dealer sites."

Where would such a system sit in the cornucopia of bond trading platforms?

"I think the current markets that are there will survive," Holland said. "This hub that we're trying to create could be the central hub for different types of trades which aren't currently happening."

High Grade Turnover by Issue Size Liquidity has become more concentrated in newer and larger issues

High Grade Turnover by Issue Size

Liquidity has become more concentrated in newer and larger issues

That would mean more pricing points and increased liquidity, he said. That then would help generate the confidence to build pricing points for dealers and clients to put capital to work through a lit order book for smaller orders or to go to RFQ for slightly larger ones.

"And I think it will create more pricing points in the market to extend liquidity away from 500 issues into the thousands," he said.

Whatever system proves popular, it's clear that buy-side firms are itching to be able to trade directly with each other. MarketAxess has introduced a new protocol on its system that allows clients, when they send an RFQ, to make it public to other investors.

By the end of Q1 2012, about 15% of enquiries were being made public, MarketAxess said. By the end of last year that had risen to around 55-60 % and by the first two months of the year it was more than 70%.

There are also plenty of single-dealer platforms for investors to choose from.

Bloomberg, so far, is not throwing its weight behind any particular corner of the market. "As we look at the crossing type networks that are out there, we see the potential for Bloomberg to play a role; however, at this point in time we're still assessing what exactly that role could or should be," Harrington said.

Pretty much everyone Automated Trader spoke to for this article believed a diverse client base will require a diverse array of execution venues.

"We're following where our clients want to go," Urtheil of MarketAxess said. "The clients are trying out different venues, different areas, different protocols to source liquidity."

He added: "I don't think it is for us, as the platform provider, to dictate how the market should actually work. I think for a variety of products and instruments, we're just providing investors with a variety of different trading methodologies. As the credit market is evolving, you will probably have liquid products like some of the CDS products that are ready for CLOB (central limit order book), and you might have other products that may never go down that route."

There is one major change afoot on the buy-side, one that could make a big difference if an order book model is to succeed

"We see more and more traders and teams from the banks moving over to the buy-side, for both alternative investment and real money firms. And we're pretty sure that the capabilities and the skills on the buy-side will actually increase significantly to play a market-making role more actively going forward," Urtheil said.

Galassi of MTS also noted that it was buy-side firms that were pushing for the ability to trade via an order book. The company has regular working-group meetings with institutions in major European capitals; some are hesitant about the idea of changing their working methods, but others are ready.

"There are a number of big buy-side firms who are definitely not reluctant [to post prices]," he said. "There's no question about it. The Cassiopeia Committee was not fully a dealer-driven initiative."

Urtheil said that ultimately, all sides had to adapt.

"I think it's for the buy-side as well as the sell-side. We see the banks now more and more combining, for example, credit and rates and FX, and two of these markets are to a certain degree already electronic. We are seeing that the banks are happy to provide liquidity going forward more electronically and on the buy-side, their behaviour is adapting in terms of making sure that they feel comfortable with what kind of information they are giving up and trading and executing on."